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Commodity Hedging in Europe The communication of the strategy used is always delicate. One must talk about it without talking about it too much or risk giving an advantage to a competitor.Some do not even dare address this point or do so in extremely vague and brief terms. Any shareholder has the right to know how the group is covered, even more so in a highly volatile period. This exercise in transparency is very delicate and highly sensitive for a number of CFOs. Here again, the listed company is penalised by a more organised and more formal publication or by the use of more restrictive IFRS accounting standards.

Commodity Hedging in Europe

by François Masquelier, Head of Treasury, Corporate Finance & ERM, RTL Group and Honorary Chairman EACT

Commodity blues

Among other things, the second half of 2008 was marked, from a market point of view, by the steep drop in the price of raw materials after its mid-year peak.

We all knew that the prices were over-evaluated. The global economic growth supported the price of commodities for a long time. Yet this market is characterised by its great adaptability. When the demand drops, the producers adjust their offer little by little (for non-agricultural matters that are subject to possible climatic contingencies).

The relative gap between the spot price and the future price has hit record levels. The spot price which we notice the most, is decidedly that of petrol (almost divided by four as compared to its highest level in 2008!). But for the prices to stabilise, there must be a balance made between offer (production to be reduced and adjusted) and demand (dropping), providing that intrinsic elements influencing the price do not interact (i.e. cold or warm weather, storms, floods, freezing, etc.). In the short term, no one predicts a real rebound of raw material prices. In fact, adjustment of the production is never immediate and the increase in production requires an activation period. The elasticity has a certain technical or seasonal inertia. In the long term (2010), an increase is expected. However, 2008 will not be forgotten. Even at USD30 a barrel, everyone would like to pollute less, consume less, recycle what can be recycled and use more renewable energy. Demand is not always driven by lower prices.

Commodity hedging: tough task but necessary

The extreme volatility of raw material markets has pushed a number of businesses to cover their exposure even more. The turning of the markets disturbed them; some were even over covered. As always, it is in a period of crisis that we feel compelled to review our hedging strategies of raw materials.

In certain cases, since raw materials are most often labelled and quoted in USD, the European company will add to the risk component on raw materials, the risk of the exchange rate USD/EUR.

Some have covered more and more in a growth market context. Today, they are puzzled and questioning their entire hedging strategy. Yet the strategy must be independent of the fluctuations of the raw material demand, which can be big. The strategy is certainly not static, but requires a certain longevity to be useful. Some companies have been burnt when first, they did not cover enough, then they became over-covered. And what should they do now?

One must add to this dimension of volatile commodity markets, the volatility of the US dollar, which adds a layer of difficulty to any treasurer’s job. Any strategy must be harmoniously articulated. Besides the price risk and the exchange risk (for a European), there remains the risk of illiquidity for certain raw materials. The last factor of complexity could come from the absence of an organised identical market. One must then make use of the hedging of similar underlying (highly) correlated stocks (ammonia and natural gas; jet fuel and Brent; Arabica and Colombian coffee, etc.) Too often the buyer cannot reflect the cost overrun on their sales, nor negotiate the agreements with their suppliers in order to ‘cap’ the purchase price.

Trading or hedging

Besides the hedging of the flows linked to buying raw materials, there are the purely speculative operations, which have been mushrooming. It is in fact useful to give volume and liquidity to the markets. Senior management and procurement have involved themselves in the hedging process, notably by adjusting the group's strategy through the purchase committees for commodities (a kind of organ of collegial decision-making). In general, policies are set for six months, as the markets move more quickly than before.

Today, climate factors (with temperature changes and pollution), political events (i.e. Russia and Ukraine for the transit of gas to Europe, conflict in the Middle East, etc.) and economics (less demand in a recession period) strongly influence the price of commodities, and not always in a controllable way.

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